This Time Will Be Different: One or More Corporations Will Blow Up from Derivatives along with Global Banks

 

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This Time Will Be Different: One or More Corporations Will Blow Up from Derivatives along with Global Banks

By Pam Martens and Russ Martens: October 19, 2022 ~

Senator Sherrod Brown, Chair, Senate Banking Committee

Today, we will be asking the Senate Banking Committee, its Chair, Senator Sherrod Brown, and one of its most knowledgeable members, Senator Elizabeth Warren, to call an emergency hearing and subpoena the testimony of two brilliant researchers for the Office of Financial Research. Those researchers are Andrew Ellul and Dasol Kim.

The men have done nothing wrong. In fact, they have done something courageous. They have effectively blown the whistle on how global Wall Street banks have, once again, endangered the stability of the U.S. financial system through their opaque and dangerous use of over-the-counter derivatives.

Unfortunately, because of the legions of lobbyists employed by Wall Street that shape and corrupt the rules of federal bank regulators, these men are prevented from revealing the names of the most dangerous banks and their most dangerous counterparties because that information is considered restricted information obtained through supervisory inspections. (We have not spoken to these researchers directly. We make the assumption that they have not released the names of the banks and their most dangerous counterparties because it is considered “supervisory” information since that is the same excuse that we have received repeatedly when we file Freedom of Information Act requests with federal banking regulators.)

We believe that the Senate Banking Committee can, and should, compel their testimony and the naming of names under subpoena because the secrets they are being forced to keep present a clear and present danger to the financial stability of the United States and thus a clear and present danger to the national security of the United States.

Andrew Ellul is Professor of Finance and Fred T. Greene Chair in Finance at Indiana University’s Kelley School of Business. He holds a Ph.D. from the London School of Economics and Political Science.

Kim joined the Office of Financial Research in 2016. He holds a doctorate in financial economics from the Yale School of Management, a master’s degree in statistics from Columbia University, and a bachelor’s degree in mathematics and economics from the University of California, Los Angeles.

Ellul and Kim first sounded the alarm in a draft report that was published by the Office of Financial Research (OFR) in July 2021. (OFR is a federal agency that was created under the Dodd-Frank financial reform legislation of 2010 to closely monitor financial threats and analyze data so that Wall Street’s global banks could never again crash the U.S. financial system as they did in 2008.)

The draft report found the following:

“We provide evidence on how banks form network connections and endogenous risk-taking in their non-bank counterparty choices in the OTC derivative markets. We use confidential regulatory data from the Capital Assessment and Stress Testing reports that provide counterparty-level data across a wide range of OTC markets for the most systemically important U.S. banks. We show that banks are more likely to either establish or maintain a relationship, and increase their exposures within an existing relationship, with non-bank counterparties that are already heavily connected and exposed to other banks. Banks in such densely-connected networks are more likely to connect with riskier counterparties for their most material exposures. The effects are strongest in the case of (non-bank) financial counterparties. These findings suggest moral hazard behavior in counterparty choices. Finally, we demonstrate that these exposures are strongly linked to systemic risk. Overall, the results suggest a network formation process that amplifies risk propagation through non-bank linkages in opaque financial markets.”

When the researchers use the term “OTC derivatives markets” they are referring to opaque derivative contracts entered into between two parties (bilateral). Typically, a global bank is on one side of that trade. Unlike derivatives that trade on exchanges or are centrally cleared, these are dark contracts with little visibility. Unfortunately, trillions of dollars in notional (face amount) OTC derivatives exist today with federal regulators doing little to rein in the risks. The researchers correctly emphasize that “Losses on uncleared derivatives are fully borne by the bank, whereas those for cleared derivatives are mutualized across member firms of the clearinghouse.” And, despite the promise of Congress to reduce the threat of derivatives through the passage of the Dodd-Frank legislation, more than half of derivatives at U.S. global banks remain non centrally cleared today — more than 12 years after the passage of Dodd-Frank.

After Ellul and Kim sounded the alarm in July 2021, they conducted more tests and did more research and updated their report and released it on September 22 of this year. This time they were more blunt about their findings, writing as follows:

“We investigate whether banks’ counterparty choices in OTC derivative markets contribute to network fragility. We use novel confidential regulatory data and show that banks are more likely to choose densely connected non-bank counterparties and do not hedge such exposures. Banks are also more likely to connect with riskier counterparties for their most material exposures, suggesting the existence of moral hazard behavior in network formation. Finally, we show that these exposures are correlated with systemic risk measures despite greater regulatory oversight after the crisis. Overall, the results provide evidence of risk propagation in bank networks through non-bank linkages in opaque markets.”

The researchers explain in their updated report that global banks are piling on to the same risky, non-bank counterparties for their OTC derivative trades; not hedging this risk effectively because at least some of these risky counterparties are not even big enough or prominent enough (our assessment) to have single name credit default swaps available with which to hedge. And, increasingly, these counterparties are not other banks that federal regulators would be looking at, but are “corporations.”

Exactly what kind of corporations are on the other side of these derivative trades? According to the researchers, there are both “non-bank financial counterparties” – which could be insurance companies, brokerage firms, asset managers or hedge funds – and “non-financial corporate counterparties” – which could be just about any domestic or foreign corporation. To put it another way, the American people have no idea if they hold a large investment position in a publicly-traded company that could blow up any day from reckless dealings in derivatives with global banks.

This is not some pie in the sky fantasy. Wall Street has a history of blowing up things with derivatives. Merrill Lynch blew up Orange County, California with derivatives. Some of the biggest trading houses on Wall Street blew up the giant insurer, AIG, with derivatives in 2008, forcing a $185 billion bailout. JPMorgan Chase blew up $6.2 billion of its depositors’ money in the London Whale derivatives scandal of 2012-2013. And, according to the Financial Crisis Inquiry Commission (FCIC), derivatives played an outsized role in the spread of financial panic in 2008. The FCIC wrote in its final report:

“the existence of millions of derivatives contracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic….”

Given this history, given the clarion siren call coming – not once, but twice – from researchers Ellul and Kim, it would be a dereliction of duty for the Senate Banking Committee to fail to call an emergency hearing on this vital matter.

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